A Once-Hidden Credit Market Has Tripled in Recent Years

(Bloomberg) -- When a beloved regional beer ramps up production, there’s always a question of whether it can gain new fans without losing what made it special. Something similar is happening with a German debt instrument known as Schuldschein, a hitherto hidden corner of the market where borrowing has tripled in recent years. Not quite a loan and not quite a bond, the traditional Schuldschein was hammered out by local lenders for solid local manufacturers. Now companies like Volkswagen AG, ArcelorMittal and U.S. paintmaker Sherwin-Williams Co. are turning to Schuldschein as a way to borrow large sums from investors as far afield as China. Some of this new-style borrowing has blown up. How well can artisanal lending fare on the global stage?

1. What is a Schuldschein?

Schuldschein (pronounced schult-shine) is an alternative way to raise funds instead of loans or bonds. Deals can run from 10 million euros ($12 million) to more than 1 billion euros, and they can include tranches of different maturities and currencies. Raising a Schuldschein is similar to raising a loan. A company mandates one or more banks to arrange a deal, which is then syndicated in a process taking about a month. After order books close, final pricing is set based on investor demand. Each tranche is then divided up into various-sized slices and issued to lenders, sometimes numbering in the hundreds.

2. How is a Schuldschein like a bond?

Deals can have maturities surpassing five years, which is more like a bond than a loan. The notes also offer much greater access to institutional capital-markets investors, such as insurers and pension funds, than the bank-dominated loan market. Investors also have the option of selecting fixed-rate pricing on tranche slices, whereas loans are always floating rate. Schuldschein lenders generally pick fixed rates for long-dated tranches and floating rates for shorter tranches.

3. Who uses them?

German banks often use Schuldschein to make loans to the Mittelstand, the nation’s network of small manufacturers. Local lenders dominate the arrangers league table, with Landesbank Baden-Wuerttemberg, or LBBW, Helaba Landesbank Hessen-Thueringen and Bayerische Landesbank at the top of the tree. About three-quarters of borrowers are smaller companies with less than 5 billion euros of annual sales, according to a European Commission report.

4. What are the advantages for borrowers?

Schuldschein are favored in Germany because they are simple to use, based on local law and private. The market is light on paperwork, with even 1 billion-euro deals only having agreements comprising a few pages at most -- a marked difference to doorstep-sized bond prospectuses. There’s no requirement to publish deal terms because Schuldschein aren’t publicly traded or covered by transparency rules under the European Union’s MiFID II regime. Further cost savings come from not needing a credit rating.

5. What’s in it for lenders?

The biggest lure is comparatively high yields from generally investment-grade borrowers. Spreads on five-year Schuldschein issued last year were almost double the spread on comparable highly-rated euro bonds, according to data compiled by Bloomberg. Lenders can also expect Schuldschein borrowers to draw down the financing, which is better than being paid low fees for providing untapped revolving credit facilities.

6. What are drawbacks of Schuldschein?

Even with recent growth, only 35 billion euros of Schuldschein were sold last year, about a 10th of the amount raised in Europe’s investment-grade corporate bond market. Renegotiating terms in the event of a cash crunch is also cumbersome because deals need to be struck with every lender individually. Restructuring a bond or loan only requires majority support. For lenders, Schuldschein investing can entail more legwork than bonds because of the lack of financial transparency and credit reports. The market is also much less liquid than bonds, partly due to a predominance of buy and hold investors. Out-dated systems and processes also deter trading and boost administrative costs.

7. How is the market changing?

The growth of Schuldschein beyond Germany, Austria and Switzerland -- known as the DACH region -- is bringing in new investors, borrowers and banks. Asian lenders have particularly targeted Schuldschein as a new growth market. Bank of China Ltd. and Japan-based Mizuho Financial Group Inc. have both helped to manage deals.

8. How’s that going?

The downside is that expansion has also boosted risk in a market that’s traditionally seen few defaults. Investors in a 131-million euro Schuldschein were wiped out earlier this year amid the collapse of U.K. contractor Carillion Plc. The fate of a 755-million euro facility from troubled retailer Steinhoff International Holdings NV remains unclear.

9. How else is the market changing?

Digitization is the buzzword in Schuldschein at present. At least three different online platforms are competing to automate deal management, potentially replacing a mess of manually updated spreadsheets, phones calls, emails and faxes. LBBW has rolled out a system called Debtvision, while HSBC Holdings Plc has debuted Synd-X. Helaba and BayernLB are using VC Trade. All three systems are seeking to sign up banks and investors.

The Reference Shelf

• A Bloomberg Markets article explains how Schuldschein arrangers are turning to digitization to boost issuance and cut costs
• The Loan Market Association’s guide to Schuldschein
• European Commission report on private debt markets
• Bloomberg News survey shows Schuldschein investors see no more room for pricing compression, while the first-half review highlighted a growing deal pipeline

To contact the reporter on this story: Jacqueline Poh in London at jpoh39@bloomberg.net

To contact the editors responsible for this story: Hannah Benjamin at hbenjamin1@bloomberg.net, Neil Denslow, John O'Neil

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